Investors usually buy dividend stocks for the passive income they provide. It’s unusual to hear of an income share that also has excellent growth prospects. That’s why I thought I’d look further into Topps Tiles (LSE:TPT) when I heard one analyst claim that the stock could be hugely undervalued.

Number crunching

Edison Investment Research used discounted cash flow techniques to come up with a valuation of 116p a share. This is more than three times the company’s current (31 January) share price. However, while commonly used, it’s important to note that the results of these types of calculations are sensitive to the assumptions made. A different combination of inputs produces a range of results from 85p to 418p!

Perhaps a better guide is to see how the company compares to its closest rivals. Edison looked at eight companies “exposed to consumer spending on the house” and found they were valued at 15 times forecast earnings for the year ending 30 September 2025 (FY25).

The price-to-earnings (P/E) ratio for Topps Tiles is currently a more modest 10.1. If it could achieve a multiple of 15, its shares would be valued at 55.5p. That’s a 48% premium to today’s price.

The analyst believes the company could achieve a higher valuation due to its ‘Mission 365’ initiative. The directors have plans to increase annual revenue to £365m (FY24: £251.8m). And they want to achieve an adjusted pre-tax margin of 8-10% (FY25: 4.8%). However, no timescale’s been specified.

The company believes it’ll achieve a higher rate of growth from trade customers. It’s recently established an online one-stop shop (Pro Tiler Tools) for those in the business.

The stock’s also good for income. Based on an annual dividend of 2.4p, the shares are presently yielding 6.4%.

What’s not to like about a company that’s potentially undervalued by over 200% — and in the top 50 on the FTSE All-Share index for dividends?

Potential problems

Well, there are a few issues that give me cause for concern. Firstly, it’s a small company. With a market-cap of around £70m, it doesn’t have the financial firepower to withstand a major shock.

Also, the company’s largest shareholder isn’t happy. According to The Times, MS Galleon, an Austrian private equity firm, recently wrote to the company saying it had “grave concerns that the business has lost its way in recent years”. It was also critical of the group’s “complete failure” to embrace the online revolution.

Some of their dissatisfaction could be explained by the Topps Tiles share price falling more than 50%, since February 2020.

Finally, I’m concerned that the company’s totally reliant on a UK economy that’s still showing signs of fragility.

What should I do?

Although never guaranteed, I see no immediate threat to the current level of dividend. However, even with a yield in excess of 6%, it’s not enough to tempt me to invest.

I think the company has potential. But I don’t see it easily increasing its revenue in a market where it’s already the dominant player.

And while I see there’s some scope to increase online sales – they presently account for around 18% of revenue – I think most people would prefer to see the tiles they are buying in-store.

For these reasons, I think there are better opportunities for me elsewhere.